- 1 Traditional IRAs, ROTH IRAs, SEP-IRAs and SIMPLE-IRAs
- 2 When clients should open or convert to a Roth IRA
- 3 Roth IRAs: Everything You Need to Know
- 4 Roth IRA vs 401k? You May Not Have to Choose
- 5 11 Unusual Roth IRA Strategies
Traditional IRAs, ROTH IRAs, SEP-IRAs and SIMPLE-IRAs
Traditional IRAs - The first type of IRA created was the Traditional IRA. Annual contributions to a Traditional IRA may be tax deductible depending on the individuals Modified Adjusted Gross Income (MAGI) and whether or not the individual and his/her spouse are covered by an employer's retirement plan. Furthermore, earnings accumulate on both principal and interest paid and is tax deferred up to the point the individual makes a withdrawal from the IRA. (See Publication 590-A and Publication 590-B for more information.)
Roth IRAs - Roth IRAs were created by the Taxpayer Relief Act of 1997 to offer individuals an alternative retirement vehicle with tax benefits that are different from those of its counterpart, the Traditional IRA. Depending on an individual's Adjusted Gross Income, contributions can be made (even past age 70 Ѕ) to a Roth IRA but are considered non-deductible. However, earnings may be withdrawn tax-free and even penalty-free when certain conditions are met. Contributions to a Traditional IRA may be converted to a Roth IRA provided the individual's AGI is not more than the then applicable limit. (See Publication 590-A and Publication 590-B for more information.)
Simplified Employee Pension (SEP-IRA) - The SEP-IRA was created to provide employers with a simplified way to make contributions to their employees' retirement income. SEP rules permit employers to make an annual contributions of up to a specified percentage of the employee's compensation* or a specified dollar amount, whichever is less. In addition, the employee may contribute the smaller of a specified dollar amount or 100% of their compensation to the same SEP-IRA as their personal IRA contribution. If the individual will be 50 by 12-31, he/she may also make an additional catch-up contribution of a specified dollar amount. However, the amount may or may not be deductible if the participant is covered by an employer retirement plan. (See Publication 590-A and Publication 590-B or IRS Publication 560 for more information.) * The maximum compensation for consideration varies depending on the cap specfied for the then current tax year.
Savings Incentive Match Plan for Employees (SIMPLE IRA) - The SIMPLE IRA plan is a retirement plan that uses SIMPLE IRAs for each eligible employee. It was created for businesses having fewer than 100 employees as a simplified and cost effective way for employers and employees to make contributions to provide retirement income. The employee may defer a portion of his/her income to the SIMPLE IRA. The employer has options of a matching contribution. There are specific deadlines and requirements for employers to adopt a SIMPLE IRA plan. (See Publication 590-A and Publication 590-B or IRS Publication 560 for more information.)
When clients should open or convert to a Roth IRA
Roth IRA accounts are frequently recommended by advisers but sometimes in what seems a cookie - cutter fashion, assuming everyone should open a Roth account and that everyone with a traditional IRA should convert it to a Roth at any time. In fact, however, whether a Roth is better for the client depends on multiple factors. This article addresses when and why a Roth account makes good sense, as well as best practices in the Roth conversion process. Using a Roth conversion most advantageously could generate a sizable after - tax return.
Roth IRA accounts are frequently touted for their tax benefits, primarily qualified distributions that are tax - free (Sec. 408A(d)(1)). Qualified distributions under Sec. 408A(d)(2)(A) are those paid or distributed after the five - year period beginning with the first tax year for which the individual (or spouse) first contributed to the Roth account established for that individual and are made either:
- On or after the taxpayer attains age 5&½;
- To a beneficiary or the taxpayer's estate on or after the taxpayer's death;
- On account of the taxpayer's disability; or
- For a first - time home purchase (up to $10,000).
Whether a Roth account makes sense depends on the taxpayer's current tax rate compared with his or her expected tax rate in retirement, when distributions will generally be made. The CPA can discuss tax rates with the client, along with the types and sources of income the client has now and anticipates later. Obviously, a big unknown is what future statutory tax rates will be. One could argue that, historically, tax rates are lower than in the past, and, therefore, they likely will only go up. However, one also has to consider that the higher rates were in effect before passive activity loss or at - risk rules were enacted and that no one knows what future rates will be.
Generally, if a client's tax rate is expected to be much higher in his or her retirement years, a Roth account can provide value. The distributions will already have been taxed when initially contributed or converted to the Roth account. Unfortunately, however, the taxpayer may view the analysis as a cash flow issue. The Roth will provide no current tax benefit via a deferral of current income tax on contributions. If an individual anticipates being in a significantly higher tax bracket later in life, then it would be best to forgo a current - year tax deduction, such as that provided by a pretax retirement account contribution (e.g., to a Sec. 401(k) account or a traditional IRA) and to make Roth contributions or a conversion.
Therefore, Roth accounts cannot be recommended across the board; every client's needs and resources must be analyzed. Most financial planning scenarios anticipate that individuals will live in retirement on perhaps 70% to 80% of their preretirement income and will have a lower tax rate. For them, a Roth account might not make sense.
Other factors include the type of income received or expected in retirement, such as qualified dividends or tax - exempt interest. In addition, Roth IRAs are not subject to required minimum distributions (RMDs), so these accounts can grow far into retirement. Note, however, that designated Roth accounts ("Roth 401(k)s") are subject to RMDs; therefore, a Roth 401(k) should be rolled over into a Roth IRA to avoid the RMD rules.
Time - value - of - money concepts can help reinforce with clients the need to analyze Roth account planning.
Example: Assume a 30 - year - old has no retirement plan currently at work, so a traditional IRA contribution can provide an adjustment to arrive at adjusted gross income (AGI) in calculating his tax liability. He saves $100 every month and wants to put a year's worth of these savings ($1,200) into either a Roth account or a traditional IRA, along with the current - year tax savings he will realize from making a contribution to a traditional IRA. The taxpayer will not make any distributions from the account he contributes to for 30 years, and it will earn 5% annually. Table 1 compares the future value of the investment in a traditional IRA versus a Roth account where the taxpayer has a constant tax rate throughout the entire period of investment and retirement of 30%.
Table 1 shows that with all things remaining equal, including current and future tax rates, it makes no difference in which type of account the taxpayer's retirement contribution resides; both the Roth account and the traditional IRA have the same future value.
Next, in Table 2, assume the same conditions as in Table 1, but with a current tax rate of 30% and a tax rate in retirement of 40%.
Table 2 shows that with a higher tax rate during retirement, the taxpayer comes out ahead with a Roth account. Next, Table 3 shows the reverse, with a current tax rate of 40% and a tax rate in retirement of 30%, resulting in a higher future value for a traditional IRA.
Comparing a traditional and a Roth IRA can suggest another consideration when a taxpayer wants to contribute the maximum amount into a traditional IRA or a Roth account. For 2015 and 2016, the maximum contribution is $5,500 (or, for an employer plan, 100% of compensation includible in gross income, if less) or $6,500 for taxpayers age 50 and older. The tax benefit from the IRA deduction can be invested in an ancillary taxable investment account. Here, the tax benefit cannot be included in the IRA account (growing tax - deferred ) because the maximum annual contribution was made. With a 30% tax rate, an extra $2,357 would be invested in a separate, taxable account ($5,500 ÷ (1 − 0.30) = $7,857; $7857 − $5,500 = $2,357).
This aspect of a Roth analysis may only apply to Roth IRAs vs. traditional IRAs and not to Roth 401(k)s vs. traditional 401(k)s. This is because the IRA can provide a tax benefit in the form of an above - the - line adjustment in determining AGI, which may help provide a refund for the taxpayer, which in turn may yield a cash lump sum (tax refund) to invest, while the 401(k) tax benefit would be realized in each paycheck in an amount that would have to be set aside for investment. In either case, this strategy is often burdensome and usually not cost - effective for the CPA and the investment adviser to plan and analyze. This additional investment strategy also requires considering the investments chosen and taxes due on the investment results.
Amounts in a traditional IRA may be converted into a Roth IRA by a trustee - to - trustee transfer, by a transfer to a Roth account maintained by the same trustee, or by a rollover contribution within 60 days of a distribution. The portion of the distribution or transfer that is not treated as a return of after - tax contributions to the traditional IRA is added to gross income in the year of the conversion and thus is subject to income tax but not the 10% additional tax under Sec. 72(t).
Roth conversions often seek to take advantage of the taxpayer's current (lower) tax rate and market conditions affecting the account's value. In addition, Roth accounts are intended for use in retirement and should be given time to grow and allow interest and appreciation to compound. Conversions done too close to retirement may not provide much value. Clients converting to a Roth also need to consider how to pay the additional taxes due.
One example of when a Roth conversion works well and can provide a substantial tax benefit is when the taxpayer starts a new business and anticipates losses or substantially lower income, which may result in little or no tax liability on the conversion.
Sometimes the taxpayer may be reluctant to go through with the conversion because of a dismal economic outlook. To pay tax on the fair market value of the account and later have the account value decline will only leave the taxpayer regretful. To help protect the taxpayer from this unfavorable result, the CPA could advise setting up separate Roth IRA accounts for each investment category or sector and converting separate amounts into their own respective accounts, thus allowing a taxpayer to take maximum advantage of his or her ability to recharacterize IRA contributions (including conversion contributions).
Taxpayers are permitted to recharacterize IRA contributions, that is, change their nature to or from Roth or traditional (Sec. 408A(d)(6) and Regs. Sec. 1. 408A - 5 , Q - 1 ). If the client implements the strategy described in the preceding paragraph and a Roth account in a particular investment sector does not perform well, the taxpayer can recharacterize the contribution to that account back to a traditional IRA account. A rollover from an employer - sponsored retirement plan to a Roth IRA cannot be recharacterized back to the employer's account; it would have to be transferred to a new or existing traditional IRA.
Recharacterizations can be done as late as the extended due date for the return for the year the contribution was made (Sec. 408A(d)(7)). For example, a taxpayer who made a Roth conversion for 2015 in January 2015 could recharacterize it as late as Oct. 15, 2016 (assuming he or she has timely filed a return, i.e., filed a return by the unextended due date or filed an extension and filed a return by the extended due date). Clients who have filed timely 2015 returns before recharacterizing a conversion may recharacterize the conversion by Oct. 15, 2016, if they file an amended return for the year (on or before the due date for amended returns). For many investors, 2015 did not provide much of a return, and there may indeed be some regrets for 2015 conversions.
A taxpayer may reconvert contributions recharacterized from a Roth to a traditional IRA back to a Roth IRA again. However, the taxpayer must wait until the later of (1) 30 days after the recharacterization or (2) the beginning of the tax year following the first Roth conversion (Regs. Sec. 1. 408A - 5 , Q - 9 ).
Thus, Roth accounts can provide value and flexibility for the client, but only if they are established and maintained in the most advantageous way. With the right tools and approach, CPA advisers can analyze clients' circumstances, needs, and resources to fashion a retirement plan that may, if indicated, make use of a Roth IRA, either through regular contributions or a conversion.
About the author
David M. Barral ([email protected]) is a tax and accounting supervisor with MBAF CPAs LLC in New York City. He specializes in tax compliance and advisory services for individuals.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at [email protected] or 919-402-4434.
The Tax Adviser article
- Planning for Retirement Needs, 13th edition (#PPF1507P, paperback)
- The IRA Distribution Rules: IRS Compliance and Audit Issues (#PPF1402P, paperback; #PPF1402E, ebook)
- Cutting Your Client's Tax Bill: Individual Tax Planning Tips and Strategies (#732191, text; #163651, one-year online access)
- Sophisticated Tax Planning for Your Wealthy Clients, Nov. 10—11, Boston
- Personal Financial Planning Summit, Jan. 22—25, Rancho Palos Verdes, Calif.
For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.
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Roth IRAs: Everything You Need to Know
You may have heard of a Roth IRA, but what exactly is it? And how does it differ from a regular IRA?
We sat down with David Blaylock, a Certified Financial Planner™ with LearnVest Planning Services, to learn the ins and outs of the Roth IRA—and whether it’s right for you.
IRA stands for “individual retirement account,” and it’s a brokerage account that’s specifically designated to fund your retirement. As with any brokerage investment account, it allows you to trade securities. But unlike other brokerage accounts, IRAs have tax benefits, and the difference between traditional IRAs and Roth IRAs comes down to those benefits.
“With a traditional IRA, your contributions are usually tax deductible, meaning that the amount you put into your IRA is exempted from your taxable income,” Blaylock says. “But with a Roth IRA, you pay taxes on the money that you contribute before it enters the account.”
So if you make $50,000 this year, and contribute the annual maximum of $5,500 to your traditional IRA, you’d only be taxed on $44,500 of your income and therefore pay less in taxes. Of course, this doesn’t mean that you’re completely off the hook for paying taxes on that $5,500—you’ll have to pay them later, when you withdraw the money from your account 20 or 30 years down the road.
It sounds like no big deal, right? You either pay taxes now with a Roth IRA or pay taxes later with a traditional IRA. But, in fact, there’s a huge difference because your IRA is a brokerage account and that money is growing as we speak. If you open a traditional IRA, and withdraw that money later, you’ll be taxed on your contributions … and your investment earnings.
Let’s say that you contribute $150 per month for 20 years, which comes out to $36,000. If you earn 7% returns, those contributions could morph into $78,000—over half of which would be your investment earnings. With a Roth IRA, you only pay taxes on that $36,000—and then you’re done. With a traditional IRA, you’d be taxed on the entire $78,000 sum when you withdraw.
How Is an IRA Different From a 401(k)?
There is a third very common type of retirement account, although it doesn’t have “IRA” in the name: a 401(k). “A 401(k) is a retirement account that’s usually set up through an employer, while IRAs are created and managed by an individual,” Blaylock explains. Also, when compared to IRAs, 401(k)s tend to have limited investment options.
With a 401(k), some employers “match” your contributions to a certain point, so if you contribute, they’ll contribute some (free!) money too. “And you can contribute to a Roth IRA and a 401(k),” Blaylock adds. “So if your employer doesn’t match your 401(k) contributions, you may want to think about whether you’d prefer to bypass the 401(k) and focus on maximizing your Roth IRA instead.”
There’s one other type of account to consider: Roth 401(k)s, which work the same way as Roth IRAs—they tax you upfront, sparing your future earnings from the taxman. Although Roth 401(k)s used to be pretty rare, they’re growing in popularity. If your employer does offer this option, read our guide to Roth 401(k)s. If your employer doesn’t offer one, the only way to open a Roth 401(k) is if you’re self-employed.
Roth IRA vs 401k? You May Not Have to Choose
One of the most common retirement questions I get asked is: Roth IRA or 401(k)?
Although both are good options worth considering, the answer isn’t always as straightforward as one might think. Also, it’s crucial for you to understand that you may not even need to pick one or the other. If you’re able to contribute to a work-sponsored 401(k), there is no reason you can’t also contribute to a Roth IRA, provided you meet certain conditions.
As a side note, if you’re looking to get a Roth IRA, The Simple Dollar recommends Scottrade as a good choice due to best-in-class customer service and support.
Before we delve deeper into this debate, let’s first make sure we have a working understanding of each of these options for retirement and what they entail.
A 401(k) is an employer-sponsored deferred contribution retirement plan, so named because it’s defined under section 401(k) of the IRS code. In a nutshell, it works like this: You sign up for a 401(k) plan in your workplace and choose investment options within the plan. Your workplace takes money out of your paycheck before income taxes are taken out and deposits this in your plan. In some workplaces, your contributions are matched by the employer.
Then, when you reach retirement age, you can take money out of the 401(k), but those withdrawals are subject to income tax – since you didn’t pay it earlier, you have to pay it later on. (The benefit of the deferred tax structure is based on the assumption that you’ll be in a lower tax bracket in retirement compared to your prime earning years.)
Currently, there is no upper income limit on who can contribute to a 401(k), but an individual could contribute at most $18,000 to his or her 401(k) in 2016, and the maximum total amount that can be contributed between employer and employee is $52,000 in the same year.
- Your contributions may result in tax savings during each year you contribute.
- Your employer may offer an employer match — a.k.a. free money.
- In most cases, the money you contribute can be taken directly out of your paycheck. Out of sight, out of mind.
- You can contribute a lot more each calendar year using this option (up to $18,000 per year in 2016)
A Roth IRA is an independent individual retirement account that you set up directly with an investment firm. Its name comes from its chief legislative sponsor, Senator William Roth.
With a Roth IRA, you can set up an account with any of the online brokers, choose investment options with them, and then directly deposit after-tax money (from your checking account, for example) into the Roth IRA. Then, when you meet a few basic requirements (once you’re 59 1/2 years old or older, and have had the plan for five years or more), you can withdraw both your deposits and investment gains completely tax free. You can also withdraw funds penalty-free to pay for a child’s education or a down payment on your first house.
In 2016, the maximum contribution you could make to a Roth IRA is $5,500 a year (unless you’re over 50). However, there is one big caveat: There are income limits on who can contribute. If you make more than $116,000 individually or $183,000 jointly, you can’t contribute the full amount (and may not be able to contribute at all). You can find out a lot more detail in the Wikipedia entry on Roth IRAs.
- Your eventual withdrawals will be tax-free since you funded your account with after-tax dollars.
- You can actually withdraw your contributions at any time without penalty. (You cannot begin withdrawing your earnings before age 59 without incurring a penalty)
- Unlike with a work-sponsored 401(k), your Roth IRA will allow you to pick and choose a brokerage firm and your individual investment options.
Roth IRA vs 401(k): What Are the Major Differences?
The big differences between the two are employer contributions, investment options/management, and taxes. Let’s look at each aspect.
With a 401(k) retirement plan, an employer may match contributions made by an employee up to a certain percentage. For example, let’s say you contribute 10% of your gross salary to your work-sponsored 401(k). In some cases, your employer will match your contributions up to a certain percentage, usually somewhere between 3-6%.
When your employer offers a perk like this, it is crucial that you take advantage of it. It’s free money, after all – don’t turn it down. In a nutshell, employer contributions are also one of the advantages of using a 401(k) in the first place. Since a Roth IRA is funded only with your after tax dollars, you won’t receive this benefit when you use that particular type of account.
Although receiving an employer match when you use your 401(k) can be rather attractive, that doesn’t mean that using that particular type of retirement account doesn’t come with its own set of drawbacks. With a 401(k), you’re tied into whatever management and investment options are made available to you by the plan your company offers. In some cases, that means that your choices could be rather sparse and not all that great, although that isn’t always the case.
Important items to look out for in your investment plans are expense ratios and investment options. The best employer plans will have low expenses and as many options as possible.
With a Roth IRA, you are allowed to choose your management and thus also your investment options – you pick the investing house you want to use. Roth IRAs offer an advantage in that they allow you to choose your plan’s manager, though if your 401(k) offers good options, this may not be a big advantage.
Another big difference between a 401(k) and a Roth IRA is the way taxes are paid on both your contributions and your withdrawals. In short, your 401(k) plan is funded with pre-tax dollars, which can be beneficial since it reduces your tax liability during each year you contribute — often in the prime of your career. However, the money you eventually take out of your 401(k) will be taxed upon withdrawal at your current tax rate.
Meanwhile, a Roth IRA works in almost the exact opposite way. The money you contribute has already been taxed, which means that making a Roth contribution won’t affect your taxable income in the year you contribute. However, since you have already been taxed on your contributions, you won’t need to pay taxes when you begin withdrawing funds for retirement.
Advantage: It depends on your tax rates
How can you know which rate will be higher? Here are a few things to ask yourself.
Will my income increase between now and retirement? If the answer is yes, you’ll likely be in a higher tax bracket when you retire, which favors the Roth. If you’re near your peak, you’ll probably be in the same bracket or lower, which favors the 401(k).
Will I be working in my retirement years? If the answer is yes, you have a much higher chance of at least being in the same tax bracket you are now.
Will the political landscape shift towards higher tax rates? This one, honestly, is complete guesswork. If I had to guess, I would speculate that tax rates will go up in the future. If that’s the case, you might want to lean towards a Roth IRA since your future distributions will be tax-free. If you expect to pay a lower tax rate in the future, however, a 401(k) funded with pre-tax money might be a better bet since you won’t be taxed on that money until you retire and begin taking distributions.
Best Strategies for Maximizing your 401(k) or Roth Contributions
Contributing to at least one type of retirement account faithfully is crucial if you ever hope to retire. In most cases, Social Security funds will not be enough to sustain you, and your cash savings probably won’t have the opportunity to grow the way they would if you had invested that money all along.
When it comes to picking between a Roth IRA and 401(k), there really is no perfect answer. Your individual situation will impact which plan works best for you, and even then, there are several different ways to look at it.
It’s also important to note that you don’t have to pick one type of account over the other. You can contribute up to $18,000 to your 401(k) and put up to $5,500 in a Roth IRA or traditional IRA that same year. Here are a few different strategies you might want to consider as you move forward.
Max out your 401(k) and contribute to a Roth. If your work-sponsored 401(k) offers low fees, plenty of options, and an employer match on your contributions, you might want to max out for your 401(K) and contribute to a Roth IRA. This is a great strategy for anyone who has extra money to invest and wants to lower their tax liability.
Contribute to your 401(k) up to the company match, then begin funding your Roth IRA. If your work-sponsored 401(k) doesn’t come with the best options but you still want to take advantage of your company match, you could always contribute a percentage equal to what your employer has pledged to contribute, then focus on contributing to your Roth IRA. Young people especially should consider the future benefits of a Roth IRA since many experts agree that tax rates could go up significantly over the next few decades.
Contribute a set amount to each type of account each month. If you are struggling to decide which type of account will benefit you in the long run, you might just want to split the difference and contribute equal dollars to both. Set up your 401(k) contributions to include a percentage of your income that you can easily match in your Roth IRA. Then make a commitment to invest every month, no matter what.
Using a 401(k) means taking advantage of the investment options and brokerage firm your employer has chosen for you. However, with a Roth IRA, you are on your own to make this important decision. Fortunately, several online firms offer a vast array of financial services that include Roth IRA set-up and management. Here are a few of the best online options as well as a basic rundown of what each has to offer.
When it comes to online brokerage firms, Scottrade is known for offering low priced trades and quality customer service. However, low fees come at the cost of less than stellar investment tools and features.
Some other benefits of Scottrade:
- Streaming quotes: Unlike many other online brokerage accounts, Scottrade doesn’t make you pay extra to see streaming quotes from day one. You simply need to open an account and fill out a few forms to gain access.
- Scottrade Elite: Fund your account with more than $25,000 and you qualify for Scottrade Elite, a VIP service that opens up options for advanced tools and charting.
- Low fees and no hidden charges: Beyond the $7 flat unlimited trade fee, you can also use Scottrade without worrying about hidden fees or charges.
- Plenty of investment options: With Scottrade, you can choose to invest in everything from stocks to mutual funds and banking products. Their mutual fund offerings alone give you more than 14,000 options to choose from.
There’s a reason over six million people hold accounts with TD Ameritrade. Founded in 1971, the company has proven itself over the years by offering excellent customer service, investment professionals you can count on, and fees that are competitive with similar firms. Although TD Ameritrade charges a slightly higher fee for trades at $9.99, they offer other features that some say more than make up for it, including the opportunity to speak with a financial advisor for free during one no-obligation consultation.
Beyond the basics, here are a few of the biggest benefits that come with choosing TD Ameritrade:
- Excellent support and customer service:TD Ameritrade customer support is available 24/7.
- One of the best trading platforms in the business: Unlike other brokerage firms with somewhat basic trading platforms, TD Ameritrade is known for its superior trading platform and powerful research tools.
- No minimums: With TD Ameritrade, there is no minimum opening deposit.
- Local branches for convenience and service: Much like Scottrade, TD Ameritrade also offers convenient local branches for more personalized service.
As one of the first brokerage firms to go online, E*TRADE is one of the most established and trusted of the bunch. All E*TRADE customers have access to streaming stock quotes, various financial and investment tools, and below-average account minimums. Investors who make 30+ trades per quarter also qualify for a low $4.95 commission rate, while investors who make more trades often qualify for even lower rates. Meanwhile, E*TRADE also offers many commission-free ETFs, as well as mobile access, 24/7 customer service, and some physical branches. Beyond those basics, here are some of the major benefits that come with choosing E*TRADE:
Plenty of investment options: With E*TRADE, you’ll have access to over 8,000 mutual funds, 1,300 of which come with no load and no transactions fees. In addition, you’ll also have access to forex/future trading, which isn’t always available with other online firms.
Low account minimums: To open an account with E*TRADE, the account minimum is only $500 or $2,000 for a margin-enabled account.
Excellent trading tools: Beyond their basic trading platform, E*TRADE also goes out of the way to ensure maximum trader education with powerful trading and research tools that are available to all users.
The Robo-Advisor Roth IRA Options to Consider
While many people enjoy trading stocks and learning more about investing, others would rather minimize their fees, and use a buy-and-hold strategy.
Fortunately, there are several online investment firms that can help you manage your retirement and put you on a path toward meeting your long-term goals without ever setting foot in an office or feeling pressured to invest in high cost funds. Here are a few of the best online financial planning firms out there:
Betterment is similar to other online brokerage firms in that it provides you with a place to manage your retirement and investment accounts. However, Betterment has taken the stance that too many fees can eat into your long-term returns and adjusted their fee schedule accordingly.
To cut down on fees, Betterment uses low-cost exchange-traded funds, or ETFs, that are similar to mutual funds but able to be traded like stocks. In addition, Betterment offers a ton of comprehensive wealth management features that many of the stock trading firms do not, such as automated portfolio rebalancing, tax-loss harvesting, and automatic dividend reinvestment.
Betterment’s fees are also highly competitive when compared to traditional managed accounts. Currently, their fees range from 0.25% – 0.5%, based on your plan.
- Betterment: 0.25%
- Betterment Plus: 0.40%, $100,000
- Betterment Premium: 0.50%, $250,000 minimum
Each of these options comes with no transaction fees, no trade fees, and no rebalancing fees. However, free tax-loss harvesting is only available for the Better and Best plans. Meanwhile, individuals whose investments fall in the Builder tier (accounts under $10,000) must set up $100 per month in auto-deposits and pay a $3 per month account management fee.
Much like Betterment, Wealthfront offers low-cost, liquid ETFs (exchange-traded funds) in order to cut down on the overall cost of investing for its customers. Wealthfront does not allow for individual stock trading at all, however, and instead focuses on using ETFs to help you create a customizable investment and retirement plan. If your goal is to automatically invest a certain sum of money each month and have your investment automatically picked for you based on predetermined criteria, then Wealthfront could be for you.
In addition to the use of low-cost ETFs, Wealthfront also offers several benefits that can help you learn more about investing while optimizing your returns. Some of those benefits include automated portfolio rebalancing, automated tax-loss harvesting, and the Wealthfront invite program, which can help you earn free services in exchange for referring family and friends. Here’s how the fees stack up:
- Your first $10,000 invested with Wealthfront is managed for free.
- Everything you invest beyond $10,000 is charged a 0.25% management fee annually.
However, it is important to remember that you could realistically get your services for free just by signing up and getting several people to do the same with your referral code. For each person you get to sign up, you currently get an additional $5,000 managed for free. Depending on how much you have invested, and how many friends and family members you have, you could earn the right to have most of your investments managed for no out-of-pocket expense at all.
With Personal Capital, you have two options to choose from: You can either sign up for their free service in order to gain access to a number of wealth management tools for no out-of-pocket expense, or you can sign up for their paid service which includes access to a personal financial advisor.
The free service that Personal Capital offers is rather remarkable. Once you link your accounts, you will gain not only a clear picture of your net worth, but access to innovative tools such as a 401(k) fee analyzer, investment checkup tool, and a tool that shows you your ideal asset allocation target. Personal Capital also tracks your spending for you and puts things in perspective with easy-to-understand graphics and pie charts.
When it comes to the paid service, Personal Capital is one of the only options that assigns you a personal financial advisor. However, that privilege does come at a price. The following list shows just how much you’ll pay Personal Capital to oversee your entire investment portfolio:
- Accounts up to $1 million: 0.89%
- Accounts up to $3 million: 0.79%
- The next $2 million: 0.69%
- The next $5 million: 0.59%
- Over $10 million: 0.49%
Although these fees are higher than some of their competition, they are still significantly lower than the fees charged by traditional financial advisors for managed accounts. To cut down on the overall fees associated with managing your account, Personal Capital uses baskets of individual securities and ETFs to create a model portfolio. Keep in mind that wealth management, trade fees, and custody are all included, so their pricing is truly all-inclusive.
Even if you don’t choose to use Personal Capital to manage your Roth IRA and other investments, you still have a lot to gain by signing up for their free wealth management tools. Sign up and you can easily find out your net worth, how much you’re paying in retirement fees each year, and your ideal asset allocation. Signing up is free and you have nothing to lose.
Whether you’re choosing between a 401(k) or Roth IRA, or simply trying to choose which brokerage firm you want to use to make trades or manage your investments, it’s important to remember that there is never a one-size-fits-all option. To figure out what is best for you, you have to explore all of the pros and cons with each opportunity and figure out how they relate to your own situation.
The most important thing to remember is that, in most cases, time is on your side. The earlier you start investing and saving for retirement, the better off you’ll be. So take time to choose which type of retirement options is best for you, but don’t let having too many options deter you from making a decision altogether.
Hi, my company offers a Roth 401k as well as a traditional 401k. What are the advantages/disadvantages of the Roth 401k?
I think the best answer to this question is “both.” Do the 401(k) for the employer matching, and the Roth for the tax free earnings. I also don’t think contributing to just one or the other will allow one to accumulate enough to retire on, especially if you’re starting late.
I’m really lucky, my employer takes 10% of my pay and matches it in a 403(b) (works like a 401(k)). Also this year, they started a voluntary Roth 403(b) program. There is no employer matching, but I can contribute up to $15,500 per year (regular Roth IRA’s limited to $5,500 per year?) and roll it into my regular Roth IRA when I quit. Both are with Fidelity, so my investment choices aren’t too limited.
This very question was in our local Sunday paper this week. That author recommended 1) 401K to the matching limit and 2) ROTH – because he believes the income tax will go up to 30% for the lowest bracket in the next 10 years!!
“… 2:1 match for every dollar contributed to a 401(k) up to 5% of the salary. So, if you contribute 5% of your salary to your 401(k), the employer also puts in an extra 10% of your salary, effectively tripling your contribution.”
Trent please correct this 2:1 means I put 6% and employer puts 3%.
Just a correction…
Good article by the way.
Dont forget about the option of a Roth 401K. That is my favorite, as it gives you the tax benefits of the Roth IRA, but the match from your employer (generally in a regular 401K, as their contribution is not taxed) too.
The other piece to look at is your investment options in your company’s 401K. Sometimes the fees and poor options do not make even getting a match worthwhile, and it is best to invest on your own, but those cases are few and far between.
Both a Roth 401(k) and a Roth IRA for me!
Great post looking at the basics of what most people have for their retirement choices. I have a Roth IRA, since I work for myself, and I am thinking about opening a solo 401(k) or a SIMPLE as well.
Another tax consideration to keep in mind is that your tax bracket is (as I understand it) determined by your taxable income, not your total income. If your income doesn’t grow between now and retirement, but most of your post-retirement income comes tax-free from a Roth IRA or Roth 401(k), then you’ll be in a lower tax bracket then than you are now. That, I think, is a good reason to mix it up between traditional and Roth, rather than going straight Roth.
One thing that is often neglected in these conversations is whether the value of your accounts will affect need-based financial aid status for college.
Does having $10,000 in a Roth IRA make you look more wealthy when financial aid analysts determine your need and expected family contribution?
A friend who works in a welfare and social services office said that the value of a Roth IRA counts against the recipient, while 401(k)s do not. Is there a similar distinction in financial aid?
If so, for someone close to attending college or returning to grad school, it might make sense to ignore the conventional recommendations.
Like Dave, I contribute to both a Roth and my 401(k). For those few of us who max out their contributions, a Roth has an interesting benefit: it effectively lets you put more money in a tax-advantaged account. Because the Roth is after tax, it’s as if you contributed, say, 25% more than if you had put that money in a 401(k) instead. Of course by definition if you’re maxing, you’re probably maxing both the Roth and the 401(k). But thinking of it that way does open up options such as rolling 401(k)s from previous employers into Roth IRAs.
Tax rates are definitely way going up (even if McCain is elected) because of the entitlements (Medicare/Social Security) problem. If universal healthcare is implemented (Obama plan), it will be even worse. Therefore, I would get the taxes out of the way now and go Roth IRA and Roth 401k all the way, making sure you get the match. Also keep in mind that many small company “match” programs are really profit sharing contributions necessitated to avoid being top heavy, meaning that the employee will get the contribution even if there are no salary deferrals.
I have a retirement account that is neither of these: a 403(b). What’s the difference?
I think that every investor needs to have not only a portfolii with a diversified mix of investments in it but also a diversified mix of taxable and tax free investments. That’s why having both a 401K and a Roth Ira ( or just an ira) could be a good strategy for you.
If you want to save as much money as possible save in both = that’s a total of $20,500/year if you areunder 50
My husband has a Roth 401k and for now, that’s all we’re contributing to for our retirement.
We’re in the 15% federal income tax bracket, and expect to be here for at least a few more years.
Do you know if on down the road, he can switch to a regular 401k? As in, leave the Roth 401k alone to grow and open a regular 401k to put new contributions into it?
I agree with Dividend Growth Investor and Johanna – mix it up! My biggest fear for the Roth is not increased taxes, but consumption-based “fair” taxes. I’m not saying they’re fair… I’m just saying it’s possible.
We’re splitting our savings 60/40 with traditional and Roth IRAs. As we need to withdraw money in retirement, it will hopefully give us some diversity as we attempt to manage our taxes.
Thanks for the quality information about the difference between the two types of accounts. While many people might find themselves in an either/or situation with regard to a 401(k) and a Roth IRA, I believe that almost everyone’s long term goal should be to fund both accounts. Not only will that likely lead to greater savings, but it will give you greater flexibility with your taxes once you are retired.
The other thing to consider with a 401k are the hidden tax advantages. For instance, If you are married filing a joint return and your Ajusted Gross Income is below $52,000 then you qualify for a tax credit (form 8880) for putting money into ANY retirement account. You can use 401k contributions to lower your AGI to below $52,000 then your 401k and roth IRA contributions will both qualify for the credit (up to $1,000 per person). It definitely pays to understand your particular tax situation.
When I read the article, it sounds to me like you’re making an “either or” type situation: like invest in either the 401 OR the Roth IRA. I’m doing both . . . isn’t that what I should be doing to try to save the most money for retirement?
One major point to consider – it take a huge pre-tax nest egg to create enough income at retirement to be above the 15% bracket. Today, for a couple, it means taxable income of $65,100. Add the standard deduction ($10,900) plus the two exemptions ($3,500 ea) and this totals $83,000. If one follows a 4% withdrawal rate, it would take $2,075,000 in pre-tax accounts to generate that level of withdrawals.
Also, as few people go through their whole life with no disruptions, one can take advantage of periods of low income to convert from the pre-tax accounts into a Roth IRA, and smooth their marginal rate to 15% as they go.
Of course, my remarks above are somewhat moot if one has a great traditional pension plan which is going to replace much of their income. In that case the advice to go Roth or Roth 401(k) is sound. (But who has a great pension nowadays? And if you do, are you still saving a high percent of your income in retirement accounts?)
More considerations: government employees (and those with traditional pensions) can’t contribute to a 401k, though there might be an additional compensation plan available (“deferred compensation”). Often their income is greater than the deductible IRA, so the Roth IRA becomes the only other option for a tax advantaged account.
Here’s something to think about regarding the ability to access your contributions. With a 401(k) your contribution is “trapped” by penalty payment for early withdrawl along with the amount withdrawn being tax at your current income level.
The way I understand it – you can access your contributions to a Roth IRA at anytime with no penalty and no tax implication. Not a sound investment strategy and you can take it out a lot faster than you could replenish it given the contribution limits. That said I consider contributions to a Roth as a Plan B or Plan C emergency fund. To be raided before a 401(k).
I do worry that in the future there will be a way for the govt to confiscate funds taken out of a Roth that won’t technically be a tax. Say reduce your SS payments (if there are such things in 25 years) by the amount of money you take out of your Roth. Maybe something much more subtle than that does not yet exist in my philosophy.
I think your last paragraph sums it all up, contribute as much as you can to both retirement vehicles.
If you can’t afford to max out both plans, contribute up to your employer’s match in your 401k and contribute the remainder you can afford into a Roth IRA. By all means, take advantage of monetary advantages being offered by Uncle Sam and your employer.
If you earn too much to qualify for a Roth IRA, you probably qualify for a traditional IRA. But, in the year 2010 only, traditional IRAs can be converted to Roth IRAs regardless of salary AND that income tax bite can be spread out over the 2011 and 2012 tax years.
As another poster mentioned, my favorite is the Roth 401k. My company just started offering this and I switched over as soon as I saw it. The great benefits of the Roth IRA, but with company match. The best of both worlds. And since I can’t come close to maxing out on a yearly basis I dont hit any sort of “cap” problem.
Jim Cramer says it best in his newest book – Stay Mad. He recommends meeting the company match first – cause that is free money and can be 100% or 50% return on your money (depending on your plan). Cramer recommends investing this money in the lowest cost funds your company plan offers. In other words he fully agrees that paying attention to fees is more important that returns in the long run.
After meeting the match, he recommends doing the Roth IRA. He says your options are better there for investing are better than your 401k – and he recommend low cost index funds if you don’t have the time to actively manage your portfolio. Beyond that he recommends investing the rest and paying regular taxes on it. The options you have outside of a 401k are simply better than what you have inside it. So match first for the free money, then max out the Roth.
How is 401(k) with employee matching “free money”? Don’t the employers just compensate that by giving you less salary?
Why not just ask for more money in the salary, and then do what you wish with that (such as a Roth IRA plan) and turn down the 401(k)?
Sorry, I’m a lazy college student and I have no idea what’s going on, but I felt it important to ask that.
I don’t like the argument that “matching money” is simply offset by a reduction in salary because you’re not making a fair comparison. While it’s true that they could give you more money, the match is actually better for you because now that money can grow tax-free until disbursement.
I like the idea of investing in your 401(k) through the match, and then investing in Roth IRAs above and beyond. The tax free growth is just such a sweet deal, and many times a self-directed Roth has better investment options than an employer-directed 401(k) plan. At least that is true in my case.
Why can’t you do both?
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As some have already pointed out, it’s good to diversify, both in your investments, and in your tax classifications. In truth, we do have no idea what the future holds, so the best we can do is diversify.
Here’s something else to think about: even when you have to pay taxes on your money, you still have a portion that can be tax free. If you and your spouse are both still alive in reirement, you can take the standard deduction and the personal exemption. So in today’s dollars, somewhere around $15K in taxable income a year can still be tax-free. Plus, depending on your goals and your values, you may be interested in donating money to charity. You’ll probably want at least some income to be able to write off your charitable donations against.
So all this to say: even if you choose the Roth IRA route, I would still suggest contributing at least some money to a pre-tax account, like a 401(k).
I agree with you Trent, bank all the 401K goodness you can, when matching is maxed its off to Roth IRA land.
Most 401(k) matching schemes are 2:1 in that I put in 6% the employer puts in 3%. Not the way you have it.
I think it is beneficial to do both. Even if the 401(k) does not offer a match, you should still invest in both. You will then have a variety of money in tax-free and taxable accounts. No one knows what taxes will be when they retire. This way you are covered if they either go up or down.
Rick’s (#21) point is crucial to the tax question. The point he’s making is that your 401(k) contributions are deferred at your marginal rate, but your eventual withdrawals will be taxed at your overall rate. Your overall rate is *always* less than your marginal rate because our tax system is progressive.
This means that when mulling over future tax rate changes, you have to compare your predicted future *overall* rate to your current marginal rate. If you think things will stay the same, the 401(k) is the better option.
The timing of this article is perfect for me. After seven years of maxing out my 401k contirbutions, I just stopped contributing. These are my reasons:
* I had (perfectly valid, IMHO) cause to raid my emergency fund. So, I want to make rebuilding my emergency fund a priority.
* I have a goal of starting my own business over the next few years. But it will obviously require a good amount of savings to allow for this.
* My mortgage interest already helps my tax bracket to some extent.
* Once I get my emergency fund in order, I think I will be able to select better investment choices than the mutual funds available within my 401k.
Is this the right decision? Honestly, I don’t know. But I will continue maxing out my Roth IRA contributions. And I will continue to save the “401k money”. I will just pay taxes on it first, and then invest it on my own.
Woah, what company matches 2-to-1 to a 401(k)? Mine contributes 50% of up to 6% of my salary (so if I contribute 6%, the company puts in 3%), which I believe is pretty typical.
@ Mike Sty (#17) – Most companies that offer a 401(k) match offer the same match to everyone. You can choose to take advantage of it or not, but there’s usually no option to have them add that money to your salary instead of your 401(k). So if you choose not to contribute to your 401(k) enough to get the full match, you are passing up extra money that the company is willing to give you.
One complicating wrinkle (and one I do not hear talked about much)….
Since Traditional IRA/401k is tax deferred and Roth is not, try to split up your conservative investments into the tax deferred account and the aggressive stuff in the Roth. The aggressive/higher returns in the Roth will be tax free while the conservative investments grow at a slower pace. As long as your time horizon is long enough (to take advantage of the differences in returns of conservative vs aggressive), this is a great tax minimization strategy, provided you are investing in both a 401k and Roth.
Maybe it just me or my life style, however I have not had a 401k option for the last 10 years. Part was because my employers did not offer them, right now my husband and I at both of our jobs do not have a 401k option.
So that being said, Roth is all I know along with a few other accounts.
I make my decision based on the investment options in the 401(k). I was lucky, I worked for the federal government which has a great version of the 401(k) called the TSP, so I did both that and a Roth.
But my younger brother recently asked for my advice whether to join the 401(k) at his job or stick with the Roth IRA that he already had. I looked at the investment options at his job’s 401(k), they were terrible. Actively managed funds with expense ratios over 1%.
I told him only to contribute to the 401(k) up to the match and continue with his Roth IRA as his main retirement account.
The correct answer is both. I used to contribute 8% of my 401k at my old job, but I reduced that down to the max contribution (4%) because the menu of options we had was so terrible (basically index funds with managed fees, around 1%-2%). I put that extra money into the Roth (which I max out every year). Now my new job has better options, so I’m back at 8% and still maxing the Roth. Sometimes you need to pay attention to how good the options are in the plan before contributing too much.
I don’t think Trent made a mistake. Your company probably has a 50% match but there are some companies (most schools included) who actually put in double the amount you do (a 200% match).
@Kacie – yes, your husband can open a regular 401k at any time, as long as his employer offers it.
Once you have a job, your salary is the same whether you take advantage of the 401k match or not. Most companies offer this across the board and it’s not negotiable. Even if it was, you are limited to only $5000 in a Roth, which isn’t really enough to save for retirement.
I do a mix of both, although I do like the Roth because you can withdraw your contributions at any time. This will allow you to retire early without filling out any paperwork for the SEPP plan. Even if your investment options are terrible, you aren’t going to find anything anywhere else that gets an automatic 50% return.
I created this wikipedia page because I couldn’t find anything like it anywhere else. I think this is in a pretty clear format that compares the 4 main retirement vehicles.
The 401(k) at my work offers NO employer contributions. All of the Investment options in the 401(k) have atleast 5% Sales Charge and additional expense ratio of 0.5% or higher. In such a scenario what should I do, Should I still continue to invest in 401(k) or should I invest only in ROTH IRA?
This probably doesn’t apply to a lot of people on this website, but one point in favor of the 401K is that you usually have very little paperwork to do, you do it at work and the money comes automatically out before you see it. In short, it is very easy.
There are so many (especially younger) employees at my workplace who don’t contribute to the 401K because they are “going to start a Roth IRA”. But, they never get around to it. So instead of having a 401K that may or may not be worse than a Roth IRA, they have nothing. Sometimes convenience is reason enough to do something.
I like the Roth 401(k) since it gives me the best of all worlds:
1) employer match is pre-tax, which diversifies for tax purposes – my money is post tax and will not be taxed again when I withdraw, but the employer funds will be taxed later
2) greater contribution limits than an IRA
But I’m 33 and have a long time until retirement. About the only downside to the 401(k) plan at my work is they don’t have Vanguard funds available.
My employer offers a 401(k) plan, but with no matching. Is it worth it for me to contribute? I max out my Roth IRA every year, and have my other savings in accounts that are not tax-deferred.
@ jb (#25) “I have a goal of starting my own business over the next few years. But it will obviously require a good amount of savings to allow for this.”
In this situation, a Roth is better for you. If you take money out of a 401(k) or traditional IRA early, you not only pay income tax on it, but an early withdrawal penalty.
With a Roth, in most circumstances, you can withdraw your basis (the amount you’ve contributed) without paying income tax or penalties, since the money was already taxed.
In your case, the money will be there if you need it to start your business, but if you don’t need it you can just let it keep growing with tax free earnings.
Thanks for posting this – I had been under the impression that the total combined employee/employer contribution was the same as the individual cap – we’ll be adding more to my husbands 401k as a result. (I’m in a pension plan so I can’t do it, but his employer does have a 2 to 1 match, I’ll have to check the limits)
I agree with Dave who said both Roth 401k AND Roth IRA! My company recently added the Roth 401k option and I jumped at it! I would rather pay taxes on the $200 I put in each paycheck than pay taxes on the thousands of dollars that I will withdraw when I am retired! My husband’s wedding gift was opening a Roth IRA (which is now worth less than the amount I put in it, due to the market, but we have plenty of time for that to grow back!)
Trent, Thanks for the article! I’ve enjoyed reading about your journey!
I just had this discussion over at my blog as well. I’ve already met the amount I need to put in to my Roth 401k to get the max. employer match (not much). I was debating on whether to: stop contributions entirely and save the money elsewhere, switch to traditional 401k contributions, or do nothing at all.
I decided to stick with the Roth 401k for two reasons. One, it’s the easiest thing to do. I don’t have to change anything. Two, I also think tax rates have got to go up in the long term.
Thanks for these very helpful details! I think in the quest to work, especially for those that are running their own businesses or trying to start new careers, it’s easy to forget about the distant future as we try to live in the moment and take care of important tasks associated with just staying afloat in “the now” (especially with the current U.S. economy). It’s great to see all these pros and cons laid out on paper, as I think it’s pretty easy to get confused when talking to a financial advisor; many have their own strong opinions about which of these plans is better (as well they should if they are advising) and we don’t always necessarily get the picture from the standpoint of someone else like us that is investing and saving. It’s always helpful to see for ourselves what the reality is in terms we can understand before making decisions. Thanks a lot again for these important details!
Great summary of the issues. One point to consider is that some 401k plans offer BETTER options than an individual investor can achieve on their own. This is done by offering low cost funds to begin with and aggregating assets of contributors to reach share classes with LOWER expense ratios (think Vanguard Admiral share classes) than individuals can achieve through IRA accounts.
Also keep in mind the reason for employer matching. Sometimes it is because they are just nice folks. Usually it is to encourage greater participation thereby making full contributions possible for the highly compensated individuals at the firm. Participation must be balanced for everyone to contribute fully. (This is a vast oversimplification of complex IRS rules).
While we’re discussing 401(k) plans and their poor options, we should acknowledge that some 401(k)s are downright awful. I’ve got one and so does my husband. They’re group annuity contracts. Heard of them? Probably not. But, if your 401(k) manager is an insurance company and your “mutual funds” are sold to you in “units” with a “unit price” that is nowhere near the NAV that you can look up on any stock quote site, guess what you’ve got? Yep. You’re invested in a group annuity contract that is backed by mutual funds.
The fees are nearly impossible to find because insurance fee disclosures are state-regulated, but a typical number would be 1.3% on top of the mutual fund fees.
Further, consider that your 401(k) is locked to your job. The ONLY way to move that money to a better-performing investment company is to QUIT YOUR JOB. Quitting will allow you to move it to a rollover IRA with the investment company of your choice.
Also, if your company offers a lousy 401(k), and you’re in a high tax bracket and want tax-free contributions, you’re out of luck. You’re considered “covered by a retirement plan” and a tax-deductible IRA is only an option for those who don’t end up in a high tax bracket.
For people working in education and other non-profit sectors, a 403(b) is roughly equivalent to a 401(k) in terms of the advice given above.
But I haven’t seen mention of one aspect that some people may find important…
Taking funds out of a 401(k) before retirement often comes with a penalty (except for rare instances), but if I recall correctly you can take your contributions from a Roth IRA at any time without penalty, you just can’t touch the gains until retirement. So…while having a separate emergency fund is always a great idea, this could serve as a secondary buffer in case of something truly tragic and expensive.
As I work for a public school system, I do not have a 401(k) option, but a 403(b) option. Regarding tax advantages for married/filing jointly under 56K (which is my situation for the next few years): does anyone know if the 403(b) carries those same tax advantages?
401(k) and 403(b) plans are virtually interchangeable when talking about tax law, so you should qualify for the retirement savings credit if that is what you’re referring to.
Wonderful discussion, and I have to agree with what’s already been said: if you are able to contribute a substantial amount towards your retirement, the question shouldn’t be which retirement account to choose, but rather, how much to put into each one, and where to invest that amount. Answering those questions starts to get much more complicated and dependent on individual situations, though, and leads to confusion.
I’m with K regarding Roth IRAs; the ability to withdraw the principle early without penalty is a big plus in my book. The ability of a Roth to thus serve as a last-resort emergency fund as well as a source of early retirement money increase its value even more. (I suppose this is not an unmitigated positive, though, as there are some people who will withdraw from a Roth without having a really good reason to do so. For people who can resist such temptation, though, it’s another point in Roth’s corner.)
As for taxes (and the implications thereof), the simple fact is that with the National debt climbing as high as it is, something is going to give if the U.S. is to avoid going into default. The only options besides higher taxes are (1) dramatic across the board cuts in spending (which might work, but getting politicians to agree what to cut and doing so by enough to make a real difference, is going to require a vastly different political environment than I’ve seen in my adult life) or (2) allowing inflation to increase dramatically, eroding the real value of our current debt (and also the real value of our savings, investments, and salaries). Ultimately, it’ll probably take a mix of all three in order to get the national debt to a more manageable level, but the point remains: there’s almost no chance the post-Reagan tax rates we’re currently experiencing will remain this low, so investing in a Roth IRA/401(k) is definitely a smart idea.
Although… As Stacey mentioned, there is the possibility that our tax system could be converted to a ‘fair tax’; where the bulk of taxes would be collected through a national sales tax. In this case, unless there is some kind of compensation or allowance included in the new tax law, Roth holders will be screwed: they’ll have been taxed on the income that went into the Roth, and taxed again on the spending when the money comes out. (401(k) or Traditional IRA holders will benefit, though, in having completely dodged the income tax bullet, even if they still have to pay the new national sales tax as they withdraw their savings.)
However, while such plans do have some good points (easier to administer, decreases consumption, no disincentives to saving or investing), there are problems that (in my opinion) will keep it from gaining traction, the biggest being the regressive nature of the tax. (If I, a person making half my salary, and a person making twice my salary all spend the same amount in a given year, we’ll all pay the same amount in taxes, but the person who makes twice my salary will have paid a much smaller portion of his income than me, and I will have paid a smaller portion than the person making half my salary.) There are ways to remedy this situation (like per capita checks sent out on a quarterly basis), but without a truly comprehensive plan, I don’t see this as an issue in the near future.
I just cough up 9 percent to the 401k Gods every paycheck in the riskiest Vanguard fund they offer. I am only 25 so I figure what the heck. Also, my employer does not match the 401k contributions because I get a GREAT pension. But, when I get married, we are going to start maxing out a Roth.
Thanks for explaining that stuff in “dummy” terms. I have contributed to a 401k for years but I never really have known what I am doing, so that was nice of you.
We’ve always maxed out our 401k and Roth IRAs so I’m not sure. But if I had to pick I’d do match, then Roth IRA, then back to 401k.
Even though I live in a high COL area that pays higher salaries overall, I’m no better off but still face a higher tax bracket. Right now, it’s critical that I minimize my current tax burden. That points straight to 401(k).
But I’m also planning for contingencies with a Roth IRA. Not contributing to the max, but probably 80/20.
As things change, I’ll reevaluate.
Thanks, Kevin. I wish I had known that a couple of years ago 🙂
You can always go back and amend your old tax returns! Usually 3 years worth depending on when they were filed.
Scariest words in personal finance…..
Thank you for this, as a Canadian I was very confused when this subject would come up, but now at least I understand the basics. This is probably a good measure of how well you explained it.
If you ever need a tutorial on RRSP’s, RESP’s, RRIF’s, HBP’s, LLP’s or tax-free savings accounts (new in 2009!) let me know. 🙂
Anne Marie, my company recently started offering a Roth 401(k) in addition to a regular 410(k). I’ve been hesitant to switch, though. Do you think I should?
One thing I never see mentioned in this discussion is that 401ks are considered pension plans and protected from lawsuits and bankruptcy. IRA are not and can be seized creditors.
You save money on your 401(k) contributions based on your current *marginal* tax rate.
When you take money out in retirement, you will pay taxes based on your overall *effective* tax rate.
It is highly unlikely that your future effective tax rate will be higher than your current marginal rate unless your marginal rate is very low now (0 or 10%).
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11 Unusual Roth IRA Strategies
I converted funds to my first Roth IRA back in 1998, the first year they were available. Since then, I’ve not only made additional Roth IRA contributions, but found fun and exciting ways to use my Roth IRAs for even more powerful strategies.
Most readers know the basics of Roth IRAs (contribute after tax money and withdraw tax free in retirement), but it’s some of the additional, unusual strategies that you can use the Roth IRA for that make it an even better tool for wealth building.
source: Jeff Rose on Pinterest
- Contribute more than the limits allow. When I was working, I discovered a great Strategy to Contribute More Than Roth IRA Limit Allows by making additional after tax contributions to my 401k, withdrawing the contributions, and then converting to a Roth IRA. The strategy allows you to convert additional money to your Roth IRA beyond the current Roth IRA limits.
- Avoid taxes on Roth IRA conversions. Avoid the pro-rata treatment of Roth IRA conversions by moving deductible IRA funds into your 401k first. What’s left is your non deductible IRA funds to make a Roth IRA Conversion Tax Free.
- Minimize taxes on Roth IRA conversions. If you are converting taxable IRA money, you can follow the Roth Conversion Strategy to Minimize Taxes by creating multiple Roth IRAs, converting, investing each in a different asset classes, then recharacterizing the conversions that went south. You’ll avoid paying taxes on money you lost, without having to recharacterize the entire conversion, allowing you to keep the conversions on the winners!
- Use a Roth IRA to smooth income and pay less tax. Roth IRAs are a great tool to smooth your income between years and pay lower overall taxes by moving tax deferred accounts to Roth IRAs in low tax years and going the opposite direction in high tax years. I put together an example in the Unconventional Roth IRA Strategy to Lower Tax Bill.
- Use the Roth as an emergency fund. A Roth IRA can be used as an emergency fund. Jill asks Should You Use a Roth IRA as an Emergency Fund? and lays out the pros and cons.
- Use a Roth 401k to get an employer match. The good news is that the popularity of the Roth IRA didn’t stop there. It expanded to the workplace where many employees can now take advantage of a Roth 401k. This is good news for those of you who wanted to fund a Roth IRA, but didn’t want to do so at the expense of losing an employer match, or you want to fund both a Roth 401k and a Roth IRA at the same time. Now you can get the best of both worlds. However, the Roth 401k isn’t for everyone, check out the arguments in To Roth 401k or Not to Roth 401k?
- Tap your Roth IRA early. You can tap the Roth IRA early, which is great news for early retirees, since it provides a lot of flexibility. Since you can withdraw your contributions at any time tax free it provides a lot of options in retirement planning. Here is How to Make Early Roth IRA Withdrawals to avoid early distribution penalties.
- You don’t have to make RMDs during your lifetime. Another layer of flexibility for retirees is RMDs. Since Roth IRAs don’t have required minimum distributions, you can keep the money growing tax free as long as you want, while you are alive. However, RMDs do kick in after you die; inherited Roth IRAs are subject to RMDs.
- Make partial Roth IRA conversions. Like many benefits of the Roth IRA, there is also a lot of flexibility with the conversions. When determining if you Should Do a Roth Conversion, one of the options to consider is that you can convert the full amount or just a partial amount of your IRA in any year. That opens up the ability to “fill up your tax bracket” with conversions to take advantage of low tax brackets. If your income is higher than expected you can always Reverse Your Roth IRA Conversion.
- Give your kids a Roth IRA. Open a Roth IRA for your Kids. There is no minimum age, as soon as your child has taxable earned income you can contribute to a Roth IRA for them. Investment income doesn’t qualify though. To say that I can’t wait to open a Roth IRA for my kids is an understatement!
- Track your Roth IRA. And finally, How to Track Your Roth IRA Contributions… and Why You Need To! To execute any of these strategies, you’ll need great Roth IRA records, and it is up to you to keep them for yourself.
This article is part of the Roth IRA Movement designed to educate people about the benefits of a Roth IRA. Don’t forget you have until the tax deadline to make a Roth IRA contribution for 2011!
What are your favorite Roth IRA strategies?